A move towards the creation of the banking union in Europe is one of the fine endorsements to Paul Romer's principle that "A crisis is a terrible thing to waste". Banking crises and turbulence in financial markets over the last few years have provided ample ground for a grand comeback of some old ideas on integration of banking supervision in the eurozone. Not only in the form of common rules and practices, but also as an institutional integration of supervisory authorities.

It would, of course, be wrong to conclude that an incomplete financial architecture of the EU, and in particular of the eurozone, was the only cause of the banking and financial crisis in Europe. Much blame goes to deregulation, or the so called soft-touch regulation which had been on vogue in the developed world since the nineties as well as to the repeal of the Glass-Steagal act. Basle II accord followed soon. It relied on a riskbased approach to the capital requirement for banks, one that left them with almost no capital to absorb losses when things started to go wrong.

Leverage was practically under no control at all. I remember a number of  conferences and meetings in the 2000s at which serious people seriously claimed that the best regulation of the banking sector is self-regulation, i.e. that industry always knows better than regulators how to manage risks. Not surprisingly, these days they don't like to be reminded of those discussions.

At the same time Europe created a monetary union. Although some claimed from the beginning that a monetary union requires a banking union, strong unwillingness to accept any possibility of risk sharing through fiscal transfers, and an equally strong national willingness to keep control over the domestic banking industry have kept these ideas at bay. And it seemed for some time that things are working fine for the eurozone. Money market was fully integrated, financial integration was increasing, inflation was under control, and interest rates converged. But then, the crisis spilled over from across the Atlantic. Things were quickly reversed. It turned out that regulatory framework established over the previous couple of decades was completely inadequate, as well as supervision in many countries. Shortcomings of the financial architecture in Europe accentuated problems, contributed to divergence in the banking and financial markets and, therefore, deepened the crisis.

Dangerous interplay between sovereign debt crisis and weaknesses of some national banking systems fostered the redesign of the European regulatory architecture for supervision and banking resolution, and even brought to the front the discussions of common deposit insurance scheme. All eurozone member states confirmed a joint determination to move ahead with the process of creating a banking union, albeit expressing from the start the differences with respect to main elements, the end-result and the way of  getting there. These differences, as we witness these days, will not be easy to resolve.

High level of financial integration with intensive cross-border financial activities in the EU and strong inter-linkages in financial stability conditions among countries and between banks and sovereigns make the banking union both reasonable and necessary for the sustainability of the eurozone project. Ongoing institutional and policy redesign aims in particular at mitigating accumulation of systemic risks while averting adverse feedback loops between weak banks and sovereigns. Main instruments for achieving such a goal were set. One of them is harmonization of the remaining banking regulation, together with introduction of common supervisory practices. That is a clear precondition for the establishment of the banking union because, at the moment, due to different supervisory standards and practices, we cannot even compare basic indicators of the state of the banking sector in Europe, like NPL's or coverage ratios. The other one is more effective supervision in order to insure timely intervention in banks, which was not always the case, due to regulatory capture, be it by industry or by politics. The final one is introduction of common rules and mechanisms for dealing with troubled banks, as well as a common deposit insurance scheme. Common safety nets and backstops together with a single supervisor should ensure less cost and swift resolution, therefore reducing potential fiscal burden, breaking the negative feedback loops between banks and sovereigns, and allowing for more effective conduct of monetary policy. There are more advantages. Banking union should avoid national ring-fencing. Also, there should be less need for cross border  coordination between supervisors, which does not always proceed smoothly. Compliance costs for cross border banks should be reduced. Finally, the banking union has a potential to facilitate coordination of macro prudential policies and ensure that positive long-run benefits and negative short-run costs of macro-prudential policies are internalized not only nationally but also Union-wide.

That all sounds fine and logical and has initially led to the determination to pursue a full-blown banking union which has in turn helped to calm market sentiment which helped in eliminating tail-risks arising from redenomination. However, there is still a number of major uncertainties about the profile of future risks to financial stability. The majority of potential negative effects arise from the transition to the envisaged structure of the banking union. The final structure is not yet determined, the implementation process is a continuous one with many important decisions to be made along the way, while many unknowns remain, and they are likely to remain for some time in the future.

First of all, before the implementation of the SSM, a new round of EUwide stress tests is expected, this time coupled with an asset review process required to provide a clean slate of health to the banks entering the SSM. With remaining significant differences in national regulatory frameworks inhibiting precise estimates of potential capital shortfalls, surprises are still possible with respect to additional capital some banks may need. Second, not all pillars of the banking union will be functional immediately. It is usually reasonable to assume that the difficult and lengthy decision making process in the EU is making some elements of the legislation appear later  than initially expected, and often in a diluted format. For others, such as for the deposit guarantee scheme, it is still unknown whether it will appear at all. A very important current open issue is how to devise "bail-in" tools or, more generally: who pays, how much and in which order amongst the shareholders, creditors, depositors, public, the ESM and potential future resolution fund? Existence of the common backstop and safety net, coupled with transparent 'packing order' could also allow for a change in the European resolution culture, in which, so far, even the small banks were usually not allowed to fail, or liabilities got fully guaranteed. That creates moral hazard even at the low level where it, for example, does not exist in the American resolution culture. This issue is of the utmost importance, but the bail-in principle is particularly important in countries with oversized banking systems. While bank resolution in the case of Cyprus offers some direction on the future application of the bail-in principle, its application also had a number of adverse consequences one should seek to avoid in the future. Resolution tools should be devised in such a way as to deal with the most harmful side-effects of bank resolution so that the need to introduce lasting capital controls in the future is avoided. Even more complications may arise in resolution of cross border banks. Again, the question is who pays the bill, but, unlike the bail-in principle, there might be less scope for application of common rules, and, therefore, more uncertainty regarding end results.. Finally, lack of experience and the need to create institutional capacity for supervision or macro prudential policies at the ECB level can prove to be a drag on the process as a whole. 

Despite clear benefits, new instruments and mechanisms envisaged for strengthening the financial stability and the single market within the eurozone may have adverse effects for some member states, particularly for non-euro area countries. Common set of rules and a possibility of participation in the single supervisory mechanism aim to preserve and even enhance the integrity of the common market in financial services. However, introduction of two different supervisory and bank resolution regimes, one for banks operating within the eurozone, and the other set of regimes for banks operating in countries that remain outside, may tilt the playing field in favor of banks operating within the eurozone. In turn, this could promote suboptimal capital reallocation strategies and introduce competitive distortions. Such a scenario is especially relevant for CEE countries that stay outside of the euro area, while their banks remain dependent on external financing.

The proposals of the Single Resolution Mechanism (SRM) and Deposit Guarantee Schemes (DGS) in particular have the potential to break adverse feedback loop between weak banks and sovereigns. On the other hand, maintaining reliance on national resolution and deposit guarantee mechanisms or setting up non-obligatory contribution mechanisms like the European System of Financial Arrangements might slow down resolution and recovery of troubled credit institutions and prove unable to prevent negative spillovers between banks and countries. Even if the SRM and DGS over time get the financial ammunition to deal with potential problems, if the status of the non-euro zone member states will not be resolved; this might put banks from those countries in a disadvantaged position on the  common market. Inclusion of banks from non-euro area countries in the SSM without providing access to adequate common backstops and safety nets might create new market frictions. Frictions can also arise from having only systemically important banks, rather than all banks, included in the fully fledged banking union.

Some of these and other considerations, viewed from the perspective of possible opt-ins, were voiced less than two weeks ago at the 19th Dubrovnik Economic Conference held by the Croatian National Bank (CNB). Some policymakers emphasized also that indiscriminant application of the bail-in principle can have detrimental effects on investor confidence and financial stability. On the other hand, leaning too much on the single supranational authority to cover costs of bank failures risks encouraging moral hazard as well as weaker pressure for reforms of economies and banking sectors which might need consolidation. Another issue is the treatment of SIFIs, which from the local market perspective is not yet clear enough. Experience and institutional memory is undoubtedly important for supervision and monitoring practices, while domestic economic conditions might vary substantially, so there was a great deal of consensus that macro prudential regulation should necessarily be used on national level. In CEE macro prudential measures have been widely and usefully used before the crisis. In Croatia, for example, we used many instruments for which we were only later told that they were macro prudential tools. A the time we introduced them, we were told that these were heavy handed communist tools out of synch with the times of soft touch regulation. However, they enabled the banking system to be well capitalized, with capital adequacy of  over 20 per cent, liquid and lowly leveraged, so it sailed through the turbulent times of the crisis well.

Some non-eurozone countries have already made a decision whether to join the banking union or not. In Croatia we would like to see the final form of at least the main building blocks before we make a decision.

As for the eurozone, it is facing a financial stability trilema or the new impossible trinity - inability to pursue financial stability, financial integration and national financial policies, all at the same time. The choice is either to adopt policies that deal with the problem or to wait for another, deeper crisis to make the problem even more obvious. I do hope and believe that this one will not go to a waste. A need for a fully fledged banking union is almost a matter of common sense. But, as Mark Twain said: 'Common sense is the least common of all senses'.